P/E: THE BASIC INVESTMENT TECHNIQUE

P/E represents the “relative form” of investment valuation. In other words it says that same assets should trade at same prices.

Many people consider stock selection in stock market as a very difficult job, something that is beyond their understanding actually this is true that stock selection is difficult but it is in no way beyond a “layman understanding”. Don’t believe me? Just read this article completely and see for yourself.

What does P/E mean? It is simply a ratio of Price/Earning. Price is the quoted market price of share in the stock market and Earning is the Earning per Share (EPS) easily found on company’s financial statements. The best way to understand this concept is to consider an example. I will simply use the numbers without quoting any currency.

Suppose there are two companies of cement industry:

Company 1: X
Company 2: Y

Now consider their share prices on stock market:

Price (X): 100
Price (Y): 50

If I ask you which company is expensive you might say Company X because its share is selling for 100. But I didn’t show you the complete picture. Consider the earnings (EPS) of same two companies:

EPS (X): 20
EPS (Y): 5

Now have your changed your mind? Let me explain this. Share of Company X is selling for 100 and it is earning 20 for every share. On the other hand share of Company Y is selling for 50 and it is earning only 5. Since price of Company Y is exactly half of Company X so its earning should also be half of Company Y’s earning but that is not the case. The earning of Company Y is 25% of earning of Company Y. Company Y is certainly expensive. Let me describe the same thing in different and more intuitive way.

Suppose you have 100 to invest. You are wondering whether to invest in Company X or Company Y. If you invest in Company X then you will buy one share and at the end of year you will get 20 (we are supposing that company is paying all of its earnings). Now if you decided to buy Company Y you will buy two share of Company Y at 50 and at the end of year you will get 10 in earning/dividend, 5 for each share. As you must have realized you invest 100 in both scenarios but end up with 20 in case of Company X whereas in case of Company Y invested the same amount but get only 10. Company X is certainly attractive and cheap.

Now finally, in finance we usually don’t see investments like that because we use a “tool” which exactly tells exactly that in much simpler way. This tool is called P/E (Price to Earning ratio):

P/E of Company X:

P/E = 100/20= 5

P/E of Company Y:

P/E = 50/10 = 5

Now finally let us summarize the things:

P (X) = 100
P (Y) = 50

From analyzing prices only it seems Company X is expensive. Now look P/E.

P/E (X) = 5
P/E (Y) = 10

Now P/E is actually telling the true story as the P/E of Company X is lower and the company with lower P/E as compared to similar company is cheaper. The lesson is very simple, do not see the prices only, after considering the earning expensive share might turns out to be cheap.

THINGS MAY NOT BE THAT SIMPLE IN REAL INVESTING:

I am sure you must have understood the concept and now I can briefly dwell to the “complexity” side.

Our analysis is valid only If two companies are exactly similar. Consider the following variations:

1. What if company Y is planning an expansion that will double its capacity in two year. Is company Y expensive now? May be not or may be yes we need some more detail.

2. What if Company X is having some operational problems and there is a chance that it might need to shut half of its production capacity? Is Company X cheap now?

Let me stress that point again, if you find two companies in a same industry with different P/E and there is no “particular issue” with any of these companies then you may have got a very good opportunity in your hand. But don’t forget to analyze that “particular issue”. In fact it is this “particular issue” that we financial analyst have comparative advantage to find out and this is exactly what our job is.